Slide 3:

PREFERENCE CAPITAL
The features attached to preference shares may vary along the following dimensions:
Cumulation of dividends
Callability
Convertibility
Redeemability
Participation in surplus profits and assets
Voting rights  Centre for Financial Management , Bangalore

Slide 4:

FEATURES OF WARRANTS AND CONVERTIBLE DEBENTURES
A warrant gives its holder the right, but not the
obligation, to subscribe to a certain number of equity
shares at a stated price during specified period.
A convertible debenture is a debenture that is
convertible, partially or fully, into equity shares. The
conversion may be compulsory or optional.
In a convertible debenture, the debenture and the option
are inseparable. A warrant, however, is detachable.  Centre for Financial Management , Bangalore

Slide 5:

VALUATION OF WARRANTS
Since a warrant is like a call option on the equity stock of the issuing company, the principles of option valuation can be applied to warrants. Value of
warrant Upper limit on
warrant value Value of the
warrant Lower limit on
warrant value Stock price Exercise price  Centre for Financial Management , Bangalore

Slide 6:

VALUATION OF WARRANTS
The distance between the actual price of the warrant and its lower limit is a function of the following factors:
Variance of the stock returns
Time to expiration
Risk-free interest rate
Stock price
Exercise price  Centre for Financial Management , Bangalore

Slide 10:

EFFECTS OF DILUTION
A traded call is a side bet between investors. Hence when
an investor exercises a traded call, there is no effect
whatsover on the firm.
However, when a warrant is exercised the number of
outstanding shares goes up and the value of the firm
increases by the exercise money.
Hence, in valuing warrants, the dilution has to be taken
into account.  Centre for Financial Management , Bangalore

Slide 11:

EFFECTS OF DILUTION
Let V = value of equity before the exercise of warrants
N = number of outstanding shares
P = ratio of warrants issued to the number of
outstanding shares
E = exercise price
If the warrants are exercised, the equity value will rise
to V + pNE and the number of shares will increase to
N + pN. Hence, the share price after the warrants are
exercised will be:
V + pNE
N ( 1 +p)  Centre for Financial Management , Bangalore

Slide 12:

EFFECTS OF DILUTION
On maturity, the warrant holder can exercise the warrant or let it lapse. So, the value of warrant, on maturity, will be:
Share – Exercise , 0
price price
V + pNE
N(1 + p)
V/N – E
(1 + p)
1 V
1 + p N
Thus, the value of warrant is equal to 1/(1 + p) times the value of call option on the stock of a firm that has the same current value of equity but has no outstanding warrants. Max Max – E, 0 Max , 0 Max – E, 0 =  Centre for Financial Management , Bangalore

Slide 13:

VALUATION OF COMPULSORILY CONVERTIBLE (PARTLY OR FULLY) DEBENTURES
n It aPi n Fi
V0 =  + + 
t = 1 (1+ kd)t (1+ ks)i j=m (1+ kd) j
where V0 = value of the convertible debenture at the time of issue
It = interest receivable at the end of period t
n = life of the debenture
a = number of equity shares receivable when part-conversion
or full occurs at the end of period i
Pi = expected price per equity share at the end of period i
Fj = instalment of principal repayment at the end of period j
kd = investors’ required rate of return on the debt component
ks = investors’ required rate of return on the equity component  Centre for Financial Management , Bangalore

Slide 16:

INNOVATIVE HYBRIDS
The payoffs of innovative hybrids are linked to some general economic variable like the interest rate, exchange rate, commodity price, stock market index, and so on.  Centre for Financial Management , Bangalore

Slide 17:

EVALUATION OF HYBRIDS
Two primary economic reasons for the popularity of hybrids
Make market more complete
Provide a tax or regulatory advantage
Critics : Hybrids represent a supply driven fad foisted by mercenary investment bankers
Votaries : Hybrids represent useful capital market innovations which succeed only if they do a better job than the existing instruments  Centre for Financial Management , Bangalore

Slide 18:

SUMMING UP
The important forms of hybrid financing are preference
capital, warrants, convertible debentures, and
innovative hybrids
Preference shares may vary in terms of cumulation of
dividends
A warrant gives its holder the right, but not the
obligation to subscribe to a certain number of equity
shares at a stated price during a specified period.
A convertible debenture is a debenture that is
convertible, partially or fully, into equity shares.  Centre for Financial Management , Bangalore

Slide 19:

A warrant can be valued like a call option.
The value of an optionally convertible debenture is a
function of three factors: straight debenture value,
conversion value, and option value.
According to modern finance, convertible debentures
improve cash flow matching, generate financial synergy,
and mitigate agency problems.
An innovative hybrid is a hybrid security whose payoff is
linked to some general economic variable like the interest
rate, exchange rate, or commodity index.  Centre for Financial Management , Bangalore